Investment and Economic Activity

Read this chapter to examine factors that determine private investment and its link to output within the macroeconomy. Private investment plays an important role in the short run by influencing aggregate demand, and in the long run by influencing the rate of growth of the economy.

14.1 The Role and Nature of Investment

Case in Point: The Reduction of Private Capital in the Depression and in the Great Recession

Net private domestic investment (NPDI) has been negative during only three periods in the last 80 years. During one period, World War II, massive defense spending forced cutbacks in private sector spending. (Recall that government investment is not counted as part of net private domestic investment in the official accounts; production of defense capital thus is not reflected in these figures.) The second period in which NPDI was negative was the Great Depression.

Aggregate demand plunged during the first four years of the Depression. As firms cut their output in response to reductions in demand, their need for capital fell as well. They reduced their capital by holding gross private domestic investment below depreciation beginning in 1931. That produced negative net private domestic investment; it remained negative until 1936 and became negative again in 1938. In all, firms reduced the private capital stock by more than $529.5 billion (in 2007 dollars) during the period.

A third – very brief and very small – encounter with negative net private domestic investment occurred in 2009, when it fell by $1 billion (in 2005 dollars).

The two graphs in this case present a contrast between the Great Depression and the Great Recession. The Great Recession was bad, but the Great Depression was ever so much worse.